Brother, Can You Spare a Billion?

Last week, for the first time in seven years, England had a
government bond auction fail. This effectively means the Bank of
England offered up some newly minted bonds for sale and investors
said, "(Burp!), I'm full. Thank you anyway."

With all the talk about what the U.S. would do should foreign
investors shy away from Treasuries, we have an example right across
the pond. The answer: finger-pointing and government predictions
that the next auction will be well-received.

Here in the U.S., a failure would not occur because there are too
many "back up" buyers available. First of all, the 19 prime dealers
are all beholden to the Treasury who has made it very clear over
the years that they should buy a certain amount of Treasuries at
each auction regardless of client interest. If these dealers refuse
to lend to the Treasury, they will surely find themselves out of
future auctions and perhaps under some scrutiny by other government
agencies. This is the reverse model of the mafia loan shark: You
must lend to us or else!

Even if that fails, the Fed will surely step in. Effectively, when
the Fed buys Treasuries they are printing money. To see this, one
must realize the Treasury is selling bonds in order to finance some
sort of government spending. Well, if the government spends and
then borrows from itself to fund that spending, that is the same as
cranking up the printing press.

If, however, the primary dealers and perhaps other banks buy up the
supply for their own accounts, it will lead to inflation as well.
To see this, one must realize these banks are low on capital. Any
increase in their balance sheet - even with so-called
"zero-risk-weighted assets" such as Treasuries - decreases
important capital ratios. This leads banks to turn back to the
government for further capital injections, which then must be
funded by issuing more Treasuries.

Over the last year, the money supply - defined as currency, savings
accounts, small time deposits and retail money funds (AKA M2) - has
grown 9.8 percent and is on schedule to grow much more quickly
going forward. Rational thinkers suggest this will lead to
inflation, which it surely will if American consumers ever get
their hands out of their pockets and back into their wallets.

On the other hand, we have government in charge of the punch bowl
at this money party. As the economy shows signs of recovering, the
Fed and Treasury can dial down recent stimulus, government
guarantees and cheap money programs. This tapping of the brakes on
the economy will help keep inflation in check, but surely requires
some superhuman abilities to perform correctly. In any case, I
can't be completely convinced hyperinflation is on the way.

This monitoring activity, of course, will be truly un-populist. And
that is exactly why it is important to set and control monetary
policy independent of politics. American consumers are no different
from alcoholics in the sense that more is deemed better. Our
economy is some 70 percent consumption-based and until that changes
(think 50 years, not five), governors on a growth economy will
remain unpopular.

The joint statement between the Treasury and the Fed last week made
clear Bernanke's greatest worry that the Fed would potentially be
politicized. Specifically, Bernanke is clearly attempting to retain
sole authority to reign in the market support programs as the
economy recovers. We must retain an independent Federal Reserve to
help keep us out of inflationary trouble.

Let's all decide now to place our car keys in the fish bowl once we
get to the party.

Key Developments

Durable goods orders in February rose 3.4 percent versus
expectations for a drop of 2.5 percent. Reviewing the numbers over
the past year, orders remain some 23 percent lower than a year ago.
When economic activity slows at such a dramatic pace, the data
inevitably become more volatile leading to "surprises" like this,
which should not be confused with recovery.

The Bureau of Economic Analysis reported its final estimate for
fourth quarter's gross domestic product growth at minus 6.3
percent, slightly lower than the previous estimate. The net
downward revision to estimated activity was $2.9 billion.

Personal income continued to decline, while spending picked up 0.2
percent in February. Contrary to the hope that the economy has
bottomed, job losses continue to rise and incomes continue to fall.
Though spending has picked up somewhat in the first quarter,
analysts attribute this to pent-up demand from the fourth quarter
along with rising gasoline prices.

Last week, for the first time in seven years, England had agovernment bond auction fail. This effectively means the Bank ofEngland offered up some newly minted bonds for sale and investorssaid, "(Burp!), I'm full. Thank you anyway."

With all the talk about what the U.S. would do should foreigninvestors shy away from Treasuries, we have an example right acrossthe pond. The answer: finger-pointing and government predictionsthat the next auction will be well-received.

Here in the U.S., a failure would not occur because there are toomany "back up" buyers available. First of all, the 19 prime dealersare all beholden to the Treasury who has made it very clear overthe years that they should buy a certain amount of Treasuries ateach auction regardless of client interest. If these dealers refuseto lend to the Treasury, they will surely find themselves out offuture auctions and perhaps under some scrutiny by other governmentagencies. This is the reverse model of the mafia loan shark: Youmust lend to us or else!